Tax exemption for banking income does not extend to securities funded by reserve and provident funds barred from business use.

Interest on Government securities linked to a co-operative bank's reserve fund and provident fund was not treated as exempt banking income under section 81(i)(a) of the Income-tax Act, 1961. The exemption applies only to profits and gains of the banking business, and income from securities qualifies only where the funds constitute circulating capital or stock-in-trade used in that business. Because the reserve fund was statutorily and regulatorily restricted from use as working capital, and the provident fund could not be deployed in the society's business, the securities were outside the bank's banking operations. The resulting interest was therefore taxable.

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Issues: Whether interest on Government securities earmarked to the reserve fund and provident fund of a co-operative bank formed part of its banking business income and was exempt from tax under section 81(i)(a) of the Income-tax Act, 1961.

Analysis: Exemption under section 81(i)(a) extends only to profits and gains of the banking business carried on by a co-operative society. Investments which constitute circulating capital or stock-in-trade of the bank yield income from banking business, but funds that are statutorily or contractually diverted from business use do not. The reserve fund, being restricted by the Co-operative Societies Act and by the binding governmental circular from use as working capital and being withdrawable only with regulatory approval for limited contingencies, was not part of the bank's circulating capital or stock-in-trade. Likewise, the provident fund could not be used in the business of the society, so income from its investment could not be treated as banking-business income.

Conclusion: The interest from securities earmarked to the reserve fund and provident fund was not exempt as income from the assessee's banking business and was exigible to tax.

Ratio Decidendi: Income from securities is exempt under section 81(i)(a) only when the securities represent circulating capital or stock-in-trade employed in the banking business; funds statutorily barred from business use do not qualify.

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